Carried away in an Aussie dollar dance

As speculative euro carry trade surges, the Australian dollar looks set to soar beyond any highs seen so far and Australia could face a new capital inflow problem.

Global hedge funds are starting to make big returns from borrowing in euros and investing in higher-yielding currencies like the Australian dollar. If it keeps going, the dollar could soar through its previous highs and beyond.

The euro is looking like a one-way bet as the eurozone economy enters recession. The European Central Bank is likely to cut official rates below the current 1 per cent rate and policymakers across Europe are keen to see the euro fall to improve the competitiveness of European industry.

It means a huge speculative euro carry trade is re-emerging, comparable with the yen carry trade of last decade that underpinned, among other things, the growth of US subprime lending up to 2007 as well as the banking bubble in Iceland and the property bubble in Ireland.

By early 2007 it’s estimated that at least $1 trillion was riding the yen carry trade, with Japanese interest rates at zero and the yen itself weakening.

The euro has fallen more than 4 per cent in three months and with the President of the ECB, Mario Draghi, having reversed the "tight money” strategy of his predecessor Jean-Claude Trichet with two 0.25 per cent interest rate cuts so far, most economists now predict another official cut within months to 0.75 per cent.

According to Bloomberg, when the ECB held the official rate steady at 1 per cent for two years up to April 2011, hedge funds made a return of 27 per cent borrowing in euros and buying Australian dollars, Brazilian real, South African rand and Korean won.

That trade reversed after April when Trichet disastrously tightened monetary policy between April and November last year.

But now the euro carry trade is back on as funds regain confidence that eurozone interest rates are heading lower and so is the euro.

The effect of the comings and goings of the euro carry trade can be clearly seen in the Australian dollar. Between 2009 and April 2011, the AUDUSD exchange rate rose from 64 US cents to peak at $US1.10 on May 2 – a rise of more than 70 per cent.

It then fell back to below parity late last year as the carry trade was partially unwound and is now rising again following two ECB rate cuts.

If this goes on – and there seems no reason to think it won’t – the Australia dollar will see $US1.10 again, and more, and Australia will start to have a new speculative capital inflow problem.

This country already has a huge schedule of capital investment in mining and energy projects over the next few years, and if this is augmented by a lot of speculative money funded by the euro carry trade, the currency could rise beyond anyone’s expectations.

This would obviously worsen what is already shaping up to be a difficult employment problem caused by the strong Australian dollar, which is leading to falling manufacturing exports and big consumer spending on overseas travel and online shopping.

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